Build America Bonds

Build America Bonds are a new form of taxable bonds to be issued by municipalities in lieu of tax-free municipal bonds. According to the IRS brief on Build America Bonds, there are broadly three different classes, each of which differs in its program terms and Federal subsidies.

While there is some leeway in the language, the Build America Bond Act does allow states to decide if they want make interest from these bonds state tax exempt.

Build America Bonds (Tax Credit)

This type of Build America Bond is very similar to a Municipal Bond. Build America Bonds (Tax Credit) can only be issued for the same purposes that municipal bonds can be used for. For these bonds, the Treasury will provide a tax credit of 35% of the interest payment. This tax credit is not as generous as normal municipal bonds, which are often Federal, state, and local tax free. As a result, the bonds will most likely carry a higher yield to provide a tax-adjusted return which is similar to tax-exempt munis.

If the bondholder lacks sufficient tax liability to utilize the tax credit, it can be carried forward to future years.

To date, none of these bonds have been issued.

Build America Bonds (Direct Payment, Issuer Bonds)

The second, and currently most popular form of Build America Bonds ("Issuer Bonds" provides no tax credit to the bondholder but instead the issuer receives a credit of 35% of the interest paid to the bondholder. The use of the proceeds from these Issuer Bonds are restricted to only new money projects (they can't be used to refinance existing projects) and no more than 2% of the money raised can be used to pay for the issuance.

For the borrower, these bonds are not tax-exempt, requiring a higher yield to make them attractive. Issuer Bonds generally pay yields comparable to ccorporate bonds but are often state-tax exempt. Another attractive feature of these bonds is that while they pay corporate bond yields, they have the lower risk-profile of a municipal bond. Historically, municipal bond defaults are significantly lower than corporate bond defaults.

The loss of tax-exemption also broadens the market beyond just retail customers to pension plans and foreign entities and investors.

Recovery Zone Economic Development Bonds

The last category of Build America Bonds are the Recover Zone Economist Development Bonds. These bonds are similar to BAB Issuance Bonds but the Treasury will pay a 45% credit to issuers instead of a 35% credit. To be classified as this type of bond, 100% of the proceeds must be used for one or more "qualified economic development purposes." The Treasury and IRS are still working on additional guidance for what constitutes "qualified economic development purposes."

Advantages of Build America Bonds

To date, Issuer Bonds have been the only type of issuance done with BAB. In April 2009, California sold $5.23 billion in Build America Bonds. Investors liked them because they offered corporate bond returns (they paid 7.55%) and were state tax-free. California liked them because the 35% subsidy from the government meant lower borrowing costs then if they had issued regular tax-exempt municipal bonds.

Several other municipalities have also successfully used Issuer Bonds to raise money. This includes:

The New Jersey Turnpike Authority - $1.38 billion of 7.4 taxable bonds due in 2040

University of Virginia - $250 million of 6.2% 30-year bonds.

New York Metro - $750 million of 7.34% .

Despite some early success and investor interest, many investors are waiting for further guidance from the Treasury and the IRS on how the programs will work and the tax consequences of investing in these new types of bonds.